The European problem

Europe is having a problem right now. In truth, it is many problems more than a single problem. Countries in the former Soviet bloc are in a deep downturn which has been significantly worsened by turmoil in currency markets. Western European banks are hemorrhaging losses – some will probably be nationalized. Spain, the U.K. and Ireland have all seen massive property bubbles implode. Greece, Ireland, Spain, Portugal and Italy have all seen credit warnings and downgrades. And Ukraine, Hungary and Latvia are but three nations that have been forced into the arms of the International Monetary Fund for a bailout. Clearly, the credit crisis has moved to Europe in a massive way. In my view, this was always inevitable given the available evidence after the panic in September. I have written a number of posts on this very issue:

Anyone who tells you this crisis came out of the blue is lying or ignorant. Yet, policy makers have largely had their heads buried in the sand. The Germans, in particular, took a very hard line. But, now that the German economy is in tatters, they have come ’round. The question is: will the crisis in Europe lead to a catastrophic outcome? My answer is no, despite the challenges.

The Swiss

I will explain why I see a deep downturn but no catastrophic outcome using the case of Switzerland as an example. Just two days ago, I profiled a somewhat sensationalistic analysis of the situation in Switzerland from the Swiss daily Tagesanzeiger. This post received a lot of traffic because it highlighted the severity of the problems besetting Europe if the Swiss were being considered a potential Iceland.

Once upon a time, Switzerland, as banking mecca and the fifth wealthiest country in the world (one notch behind Iceland), was considered the paragon of stability and prudence. The Swiss franc was backed by gold and had importance far beyond the Swiss economy’s size. Switzerland is home to some of the world’s largest companies in a wide range of industries from pharmaceuticals to banking to consumer products.

But, during the great moderation, the Swiss lost their way. The Swiss National Bank lowered interest rates to extremely low — dare I say it, Japanese — levels. The SNB starting selling their gold at depressed prices. And Swiss banks, known the world over for safety, secrecy and security, started to muscle their way into the globalized financial arena of investment banking and trading.

The result has been a dangerous increase in Swiss franc credit abroad and a similarly dangerous increase in the balance sheets and leverage of the two remaining large Swiss banks, Credit Suisse and UBS. This presents a problem in a world of deleveraging and asset deflation because the Swiss are a small nation of 7 million without the protection of the European Union or the Euro to fall back on. This makes them vulnerable. Hence the doomsday pronouncement from Artur Schmidt about Swiss bankruptcy.

I do not believe the Swiss will go bankrupt simply because they are too wealthy, too interconnected and too important to fail. No one wants a run on the franc. No one want a collapse of Swiss banks. As a result, policy makers will address the Swiss problem and work out a solution.

Nevertheless, the lack of specifics in the previous paragraph should give one great pause. I am merely making a reasonable conjecture. I am not saying that the problems with writedowns, bad loans, and deleveraging are going to go away.

They may, in fact, become much greater because of Switzerland’s interconnectedness with the rest of Europe. Which brings us back to the broader question of Europe’s many problems.

I would break the Europe down into four distinct spheres: The Eurozone, the non-Eurozone West (like the UK, Sweden and Denmark), the EU East (like Poland, Hungary and Latvia) and the non-EU East (like Ukraine and Croatia). The problems and potential outcomes in each of these regions is different. The crux of the matter is the Impossible Trinity of a fixed exchange rate, independent monetary policy and free movement of capital. You can have two, but you cannot have all three. Paul Krugman says it best in an article from 1999:

The point is that you can’t have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain–or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today, or for that matter most of Europe).

The Eurozone

The Eurozone members have decided to forgo independent monetary policies. Individual member nations have free capital movement and a fixed exchange rate but zero control over monetary policy. That rests with the European Central Bank (ECB) in Frankfurt.

The problems mount in recession. Some members are getting devastated. Spain, for instance, is in depression already with unemployment at 14%. Ireland’s national budget is imploding with estimates for deficit reaching 10-12% of GDP. If you are Spain or Greece, you would like to print money– a lot of it. But that’s not happening in the Eurozone yet.

The result is a potential national bankruptcy for the likes of Ireland, one reason their credit rating is suffering. Will Ireland go bankrupt?  Perhaps.  It is unclear how willing other Eurozone members would be to support the country were it to run into that kind of difficulty.  The Germans are furious for having abandoned the Deutsche Mark for the Euro, which they see as a ‘weak’ currency.  Bailing out a Eurozone member would come with many strings attached.

Then, there is the case of Austria.  They too are in the Eurozone.  They have a weak banking system because of excessive lending to Eastern Europe — reaching a full 85% of Austrian GDP.  (Whether the Austrians were mentally re-creating their lost Empire, stripped after World War I, is a case for the Austrian psychologist Freud). If the Eastern Europeans run into problems, Austrian banks will fail en masse, requiring help from other Eurozone members (read France and Germany).

EU East

This brings us to EU East.  And by that I mean members of the European Union nations east of the Eurozone, which stops at Germany, Austria and Italy (Slovakia is also a Eurozone member as of Jan. 1st).  Countries in this region have seen fantastic growth rates over the past decade, but, also a huge increase in debt, asset prices, and current account deficits.  All of this points to excess.

The problem, of course, is the Impossible Trinity.  These countries want stable exchange rates, monetary policy control and free movement of capital.  But, with the excesses already highlighted, the first to go in this trio was always going to be the exchange rate.

Now, EU East loaded up to the nines with debt in Swiss francs, Euros and U.S. Dollars.  Companies, Individuals, even hospitals have huge foreign currency debt exposure (see my post "Reverse carry trade borrowing is deadly" from October).  A reader from Poland said it well:

Situation in Poland: 2008.07 – 1CHF = 2.0PLN – you can go to ANY bank and take a loan for 120% value of you new flat/apartment. i live in Warsaw, lot of my friends took that loan. unemployment rate – 10% but in Warsaw was close to 0% especially if you have a master degree and skills to work in office such as advertising agency or as financial advisor or similar type of job. Now – you cannot take a loan or rent a money from bank. one square meter is down close to 25% from 2008.07. franc is up – 1CHF = 3.3PLN within my friends unemployment rate is close to 20%. banks are full of CHF loans, even if you sell the apartment you have close to half of the money you borrowed. did i mentioned that the loans we’ve given in rates even for 50 years?

Events in Poland are mirrored throughout the region. Obviously, if Austria, Ireland and Switzerland are having problems, you can imagine it is much worse in Poland, Latvia and Hungary. Hungary and Latvia have already asked for and received IMF assistance. I expect we will see a similar turn in Poland, Estonia and elsewhere. Moreover, these nations are part of the European Union. The possibility still exists that they could receive increased transfer payments in order to mitigate the worst of things. However, the Germans would be even less willing here, I suspect — not to mention countries like Britain and Sweden, which have their own worries.

Non-EU East

Then there are those countries east of the Eurozone that do not have a rich uncle. We are talking about places like Serbia, Croatia, and Ukraine. Ukraine looks to be imploding. Other countries will surely see a severe contraction in GDP. The Impossible Trinity asserts itself here again as it did for the EU East. The biggest difference for these countries is they are outside the European Union. This means countries like Ukraine will go bankrupt, no ifs ands or buts. What this means for stability in the region is unclear given the strategic importance of Ukraine as an energy transit route. If Ukraine implodes, knock-on effects for the likes of Belarus will be severe. Russia is a whole different ball of wax that I am not considering. But, again, for much of non-EU East, the problem is foreign currency loans.


And that brings us full circle back to Switzerland. The Swiss are not a member of the Eurozone. They are not even a member of the EU. Like Norway (and Iceland, for that matter), the Swiss are on their own. This has benefits. The Impossible Trinity is a non-sequitur. One can print money and devalue at the heart’s content. The Brits have shown us the power of devaluing a currency from 2.11 per U.S. Dollar to 1.43 per U.S. Dollar. Surely, the Swiss can do the same. In fact, in the case of the Swiss, devaluation would mean that their debtors will be able to repay their loans more easily. I fully expect the Swiss National Bank understands this and is prepared to crank up the presses if they have not begun to do so already. However, in the end, printing money is not much of a solution to what ails Europe. Banks are undercapitalized and some countries are overly indebted. This speaks to bankruptcy for individuals, companies, banks, and, yes, nations. My advice on remedies is fourfold:

  1. Consolidate the financial services sector through merger, bankruptcy and nationalization
  2. Recapitalize banks full-stop.  Whether this is done with public or private monies is secondary
  3. Increase intra-EU transfer payments.  The European Union and the Eurozone are supposed to be analogous to the United States.  Call it the United States of Europe, if you will.  But, this analogy is false because Europe is much more heterogeneous than the United States.  There is an insufficient movement of private capital and people as an automatic stabilizer.  Translation:  European people and money stay put, American money and people do not.  In recession, you want movement because it evens out the rough spots.  In the absence of movement in the private sector, the public sector will have to step in.
  4. Capital controls.  The whole European mess is a result of an asset and credit bubble that failed to understand the importance of incompatibilities between stable exchange rates, free capital movement and independent monetary policy.  If you eliminate free capital movement, as Willem Buiter suggests, Europe would stand a chance of weathering the storm.

None of my ‘remedies’ is pain-free and there is considerable ideological resistance to the last remedy of capital controls.  But, Europe is in a bit of a pickle.  If politicians do not take on this challenge with both hands, much worse is to be expected.


O Canada – Paul Krugman, Slate

  1. Denis says

    Sometimes implied guarantee of stability encourages reckless risk taking, like in the case of FNME & co, “house prices only go up” etc. Those risks tend to accumulate and then come out all in a short period of time, like an avalanche.

    The Euro, and EU are both serving as such guarantees for their memebers. I can’t help but wonder if there is a huge pile of risk hidden here, risk that is set out to explode in a way to eclipse the American mortgage meltdown. There must have been conversaton in the board rooms such as “hey this looks very risky! – don’t worry, the EU will come out and save us”.

  2. Swedish Lex says

    Good post. Thanks

    Remedies 1-4 will have to be introduced in parallel, plus a few more. If it works, the EU will come out different and stronger at the other end. Right now, the signs in the sky tell me that we should be slightly optimistic. The key to success is really to get leadership from France and Germany (and the UK) plus the ECB and the European Commission.

    Switzerland is on its own, however.

    If it does not work, I do not know what will happen.

  3. Paul says

    I think the author in the above article is making a mistake when he refers to a possible devaluation of the Swiss franc. The Swiss currency is currently a free floating currency and as such cannot be devalued. Only fixed exchange rate currencies can be devalued.
    Of course, what can happen is that the Swiss Franc will gradually take beating in international currency markets and lose a significant portion of its value vis-a-vis other currencies. This would amount to a depreciation of the franc, and not to a devaluation. The latter is a conscious decision by a country’s central bank to lower the fixed rate at which the national currency can be exchanged for other currencies. It is the sort of tactical move that many Southern European countries used to resort to in the era before the introduction of the euro: an effective way to boost your exports and help get your economy out of trouble.

  4. Ger says

    “There is an insufficient movement of private capital and people as an automatic stabilizer. Translation: European people and money stay put, American money and people do not. In recession, you want movement because it evens out the rough spots.”

    Not sure about capital, but people certainly move, at the height of the boom more than 10% of the population of Ireland was from another EU country. As the economy has deflated those economic migrants have left rapidly for greener pastures. This has been a mixed blessing, lower social welfare payments, rapidly falling rents for residential landlords.
    Mass migration has devastating social effects, from a purely economic point of view it might be efficient, but visit the west of Ireland and you will readily see its negative social effects.

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